Credit Crunch Fall-Out: An Unexpected Bonus For Borrowers?

With the credit crunch’s first phase of bank asset write-downs, share price falls and rights issues nearing its peak, a second phase now looks likely to begin. Private equity groups and corporates are looking to buy back their debt where lenders are willing to sell it at a discount, not because there is any credit impairment but because they are keen to lighten their balance sheets to help them kick-start their lending business.

A trickle of debt buy-backs has already been reported. Private equity-backed TDC, the Danish telecoms operator, bought back €200m of loans at a discount. PAI Partners recently bought back second-line debt in the context of the acquisition of Lafarge and Citadel Broadcasting requested the discounted re-purchase of $200m-worth of debt.

Where a borrower has or can raise the cash and is able to use it for debt repurchase, it is a good opportunity to deleverage cheaply. For a private equity group, it may make economic sense to purchase discounted debt on its own deals as they continue to attract cash. Some 32% more cash flowed into their coffers in 1Q08 compared to 1Q07.

With banks reluctant to provide leverage, private equity sponsors find it hard to make this money work. Buying such debt at the right price is an opportunity in terms of holding for yield and a possible upside upon repayment. It also secures a position on the lender side of the fence.

However, there are legal and practical hurdles. If a borrower buys debt from a syndicated bank, technically it becomes both borrower and lender. It is therefore argued the debt is extinguished by merger of interests. The rest of the syndicate, however, may be annoyed because one bank alone has effectively been repaid early, contrary to the principles of syndicated lending whereby prepayments should be shared amongst lenders.

NAVIGATING THE ISSUES

But is such ‘extinguishment’ tantamount to a prepayment? Much turns on the detail in the documents. There may be restrictions on prepayment of debt, but are there on transfers / sales? Is the prescribed transfer mechanism compatible with the concept of extinguishment by merger? Can the borrower be a lender?

Under commonly-used wording, a lender can sell / transfer, but only to another bank or other entity engaged in or established for the purpose of making / purchasing loans. So the borrower or sponsor would need to fit within that category.

Some of the debt pieces, in particular at the higher risk end, such as PIK, typically contain outright prohibitions on prepayment or repurchase, which could preclude debt buy-back. Other issues may arise in relation to where the money for the buy-back might come from. If not from available cash, there may be restrictions on the amount of new money that can be raised by the borrower, whether by way of additional sponsor share subscription, subordinated debt or otherwise.

Where it is a sponsor buying, rather than a borrower, issues such as whether it is a permitted transferee will again arise, as might certain questions concerning their tax status. Also, ‘Chinese Wall’ issues may result from the sponsor being both an investor and part of a lending group. They would also have to check that provisions which subordinate investor-debt would not apply to them in their capacity as successor senior lenders.

The Loan Markets Association (LMA), the trade body for syndicated lending, has issued a set of template documents for leveraged transactions and is currently considering issues thrown up by debt buy-back. Any new proposals will not affect existing deals, absent a renegotiation and, in any event, each deal is different.

In terms of what the LMA might do, it could suggest wording to bar certain debt purchases or perhaps only on terms, for example, where the likes of private equity groups not having voting rights in the syndicate such that the lender and borrower sides of the fence are separated.

LMA documentation already contains certain prohibitions on prepayment, which could be widened to include purchases. It could also be made clear that excess cash could only be used to buy back debt if it was at par and possibly on the same terms as if it had been a repayment and it could narrow the definition of what type of organisation could be a qualifying lender.

It may be possible, however, to structure a beneficial deal for all concerned through a process of co-operation to achieve deleveraging across the board at an agreed price, perhaps including an element of write-off or subordination of debt held by the sponsor.